Junk Bond Rally Gives Cause for Cheer — and Fear

Here's a markets riddle for you: What has jumped in value more than its biggest fans expected and withstood worries like slowing U.S. growth, European debt woes and even the specter of the U.S. losing its top credit rating?

No, it's not the stock market.

Stumped? It's junk bonds, a sort of IOU from risky companies thought most likely to not pay back their debt.

Junk has gained 55 percent the past two years, 5 percentage points more than stocks. That's good for the many brave investors who've bought junk bonds. And good for the economy, too. The hot market for junk means companies that once seemed close to bankruptcy can sell these bonds with ease and use the proceeds to run their businesses.

"Companies struggling during the recession have been able to borrow, and that's given them time and that's good," says George Cipolloni, co-manager of Berwyn Income, a mutual fund that holds junk.

The latest sign of this economic elixir at work came Wednesday. While stocks were in a two-day decline, research firm Dealogic published a report showing a record amount of junk bonds has been sold so far this year — $158 billion, nearly double what was sold during the same period in 2007, when the economy was still booming.

But this rally is not without its critics. Junk is up partly because companies are more likely to pay back their bonds and other debts now that the Great Recession is over. But Federal Reserve Chairman Ben Bernanke has also played a role in rising junk prices. That worries investors who think the Fed has a habit of inflating bubbles.

The Fed's policy of setting benchmark interest rates at zero and buying government securities has frustrated investors who are getting miserly interest payments on those and other conservative assets. That led many to rush into risky investments. To some extent, that's exactly what the Fed wanted. The hoped-for result is that money will flow more freely to companies and that investors will feel richer — and that both will spend more. Bernanke's efforts were mostly designed to push investors into stocks after many pulled money out of stocks during the financial crisis. They've fled into all sorts of assets including tradable bank loans, heating oil futures, carbon-emission credits and, yes, junk bonds.

A revived economy may justify the higher assets prices on junk that Fed policy has facilitated. But critics of the Fed note that such easy-money policies have helped lead to two stock bubbles in a decade, a credit market bubble and a housing bubble — all of which burst, socking investors with hundreds of billions in dollars in losses. When junk bonds imploded in 2008, for example, investors in mutual funds holding them lost 26 percent, according to Morningstar. Buyers were so scared that bond yields, which move in the opposite direction from their price, spiked to over 20 percent.

The big appeal of junk now is that safer assets are so unappealing. Holders of five-year Treasurys get 2 percent annually for their money now. Put cash in five-year certificates of deposits instead and you might get 2.6 percent. Junk bonds? They'll give you 6.7 percent, according to Barclays Capital.

That sounds great, but in reality, junk bond yields are near record lows and they're down 1.75 percentage points in just a year.

"Companies are more healthy now, but I'm not getting paid as much," says Andrew Smock, co-chief investment officer at Merganser Capital, a money manager that has been selling junk for several months as investors have piled into the market. "It's junk, it's risky. I can't get excited."

Referred to in polite company as high-yield bonds, junk is issued by companies that rating agencies like Standard & Poor's consider less likely to pay back their lenders. They have too much debt, too little cash or too few prospects for the kind of growth that would generate cash — or all three.

Of companies rated junk, 2.9 percent have defaulted over the past year, which means they mostly failed to pay interest or paid it late, according to Moody's Investors Services. That's better than the previous year, when 11 percent stiffed their investors. Should the recovery lose steam, defaults could rise sharply and investor returns plummet.

And if the recovery continues apace instead? Danger lurks there, too. Fast economic growth could lead to inflation. Higher prices eat into the purchasing power of a bond's principal when it's returned upon maturity and on its interest payments. Some investors in junk and other fixed income securities will sell at the first hint of inflation, which could mean losses for those still invested in junk.

So far, investors have decided to put off worrying about the risks of junk.

Consider the reception they gave a recent offering from Ford Motor Credit. On April 28, the finance arm of the car maker sold $1.25 billion worth of bonds offering 5 percent annually over seven years. Ford was thought by many investors to be on the brink of bankruptcy just three years ago. And yet demand among investors was so great, Ford had enough buyers to sell its bonds nearly three times over, says Merganser's Smock, who reviewed the deal but decided to pass it up.

The bullish argument is that Ford never collapsed and it's profitable now and selling more cars. But is 5 percent enough of a return in exchange for the risk that the company or the economy won't stumble again? Not too long ago, super-safe Treasury notes of similar maturity to the Ford bonds were yielding the same 5 percent. Treasury notes get an Aaa rating from Moody's (for now; Standard & Poor's says the U.S. could lose its top rating because of concerns about the federal budget). The Ford bonds just sold are provisionally rated Ba2, or 11 steps lower. Historically, 8 percent of Ba-rated bonds have defaulted within five years.

"Ford isn't necessarily the poster child of junk, but you're not being paid enough for the risk," Smock says. He adds that while he doesn't consider the junk market a bubble, it is "overbought."

Count Cipolloni, the money manager who praises junk's impact on the economy, among the skeptics, too. "People are more desperate for yield than they are fearful of losing principal," he says, adding that he has been selling junk recently after buying it during the credit crisis. "They're overlooking the risk."